Stock Options and Option Trading: Buy Stocks Cheaply by Selling Puts

It isn’t easy making money in the stock market these days - at least not in the traditional sense. Financial upheaval around the globe has made a lot of us turn back to stuffing mattresses as the best way to preserve cash (and invest in value). And yet, there are still ways to come out ahead, even with the market as volatile as it is now.

As many of you know by now, I’m a rabid believer in investing, molded in the buy-and-hold tradition, but in the past few years I’ve come to love option trading. We’ve already had a brief overview of options and a discussion of selling covered calls in earlier articles. Now I’d like to turn the discussion to selling puts.

As explained in previous articles, a put is the right to sell a stock at a particular price. Just like calls, puts can be bought or sold. In terms of selling puts, they can be used as a way to buy stocks at reasonable prices. The following is an example of how we would implement this strategy:

Assume Pepsi’s stock is currently priced at $70 per share. You drink Pepsi daily and would like to buy 100 shares of stock in the company, but you don’t want to pay more than $65 per share. Being familiar with options, you know that you can sell a put, which will obligate you purchase shares at a certain price, regardless of what the actual stock is trading for. That being the case, you look at next month’s options (which will expire on the third Friday of the next month) and see that for Pepsi a put with a $65 strike price costs $2.00. You sell one put contract at the $65 strike price for $200. (Strike price and contracts are discussed in the earlier articles.) You now have the obligation to buy 100 shares of Pepsi stock for $65 per share.

However, the obligation is only triggered if the price of Pepsi stock goes to $65 or lower. The reason for this is simple: the buyer of the put has the right to sell you his Pepsi shares for $65, but why would he sell to you if the market price is higher than that - say, $67 per share? He’d do better selling on the open market in that scenario. It only benefits him to sell to you when the market price drops below $65, because he can then sell his Pepsi shares to you for more than they’re worth in the marketplace. You, on the other hand, would get to buy the stock at the desired price of $65 per share. Moreover, you get the keep the $200 you made selling the put, meaning that your effective price was actually $63 per share! And if the price never gets down to $65 or lower before the option expires? Then you’re free to do the same thing again next month. And the next month, and the next…

In brief, you can sell puts as a way to buy stocks cheaply, or earn a little green every month until the price gets back to where you want it to be. Needless to say, this is a simplified version of how this process actually works. (For instance, I haven’t included the cost of commissions in my example. Moreover, all of my numbers are pretty much manufactured as opposed to being actual stock and option prices.) If you choose to invest in options, please research stock options and option trading very thoroughly.